The Fallacy of Bank Lending

Question: Why do banks ignore loan request from small business borrowers?

Their Answer: Just too much risk of default or non-repayment.

My Answer: They just don’t understand or care to understand small businesses.

Small businesses just pose too much risk for traditional lending institutions; so they say.  The default rate for small business loans (especially to new entrepreneurs without proven track records or 50% of more equity) is astronomical when compared to all lending categories – again per them.

This has lead to a very strong propensity in the financial industry to ignore small loan requests – thus ignoring small businesses and their owners.

In turn, this has created a huge funding gap for small business loans – a gap that the SBA has tried to fill with its standard loan guarantee programs without much success as they (the SBA) relies too heavily on the same banks to underwrite the loan requests.

To fill this gap, there has cropped up several alternative sources of small business funding from micro-credit loans (from non-profit micro lenders) to peer-to-peer social lenders (where members borrow and lend to each other).  These groups truly understand small businesses and their financing needs.

The amazing thing about these alternative financing sources (especially micro-loans) is that they have found real success in lending small amounts of capital to small business owners.  According to Microentrepriseworks.org, “The Mircroloan Program experienced a default rate of less than 1% in FY 2006, the lowest of any SBA loan program.”

Moreover, Zopa, one of the world’s first social lending companies, has realized defaults rates as low as 0.1%; as recently as the first of 2009 (while the world’s economies were in free fall).

Maybe this type of lending is something that the banks and other traditional lenders should be looking at.

These alternative financing sources benefit, in part, from their business models.  Example, while micro-lenders can fund up to $30,000 for start-up businesses and $50,000 for established businesses – their average loan amount hovers around $13,500.  The idea is to start business owners with small loan amounts, see how they manage those facilities and then provide them access to larger amounts.  Not only does this reduce the overall risk to these lenders especially in the beginning of a new relationship but ensure that these same business owners do not get over their heads financially right off the bat.  On the other hand, traditional banks try to push as much as possible onto the borrower at one time as this benefit only the bank – larger loans mean more bang for the buck from the bank’s perspective.

Banks also claim that they want to establish relationships with their customers but their actions show different.  If these programs can work for these alternative lenders – why won’t they work for banks?  What better way to build relationships with small business customers than to provide them some of the working capital they need to grow their businesses.  Most businesses – even though they may think that they need three times the average micro-loan amount of $13,500 to eventually get to profitability – never, ever need all those funds right up front – thus paving the way for a strong, on going borrowing relationship.

As the business grow, these borrowers can and will qualify for larger loans and more credit options – really building a relationship with their bank.  Moreover, the cross-selling opportunities that open to these institutions can further increase bank profits – think about business checking accounts, online banking and bill pay, debt cards, payroll services, merchant accounts, and so on, and so on – all of which help grow the bank’s profits as well as provides needed services for small business customers.

But, with banks merely turning way the vast majority of small business owners that request loans, they lose out on these relationship building opportunities – and, as a former commercial banker, it is these relationships that provide the greatest profit opportunities for these organizations even though we all get caught up in the thinking –“bigger means better.”

Bottom line – if banks what to find ways to improve their profits, grow market share and truly satisfy customers – they should look to find ways to bring these small business borrowers into their folds – like these alternative lenders have.  Just think about the market alone – there are some 22.5 million businesses in the US and nearly 99% of them are small businesses needing capital to start and grow their operations – that is a huge untapped market.  And, if banks continue to ignore them it will be at their own detriment – thus, the current bank fallacy.